Coinshares Research: Does Tether pose systemic risks to the cryptocurrency market?

Source: Coinshares

Author: Marc Arjoon

Compiled by: GaryMa, Wu Says Blockchain

Let's take a look at the reserves backing Tether's USDT stablecoin and compare them with other similar assets in DeFi and TradFi. The collapse of TerraUSD (UST) has heightened skepticism about all stablecoins, regardless of whether they are considered stable, and has raised new questions about what reserves support the value of these stablecoins. Investors, users, as well as politicians and regulators are expressing these concerns. Many believe that stablecoins pose risks to consumers and the broader economy.

Before the UST collapse, the total value of all circulating UST was approximately $18.6 billion, with over $17 billion (90%) deposited in Anchor. While the value lost in the Terra ecosystem was substantial (over $40 billion), its impact was relatively limited, accounting for less than 2% of the market. The case of Tether's USDT is quite different. The current circulating supply of USDT is $74 billion, four times that of UST at its peak. Below we show the relative market capitalization of TerraUSD (UST) and Tether (USDT) over the past 180 days.

The market capitalization of UST plummeted rapidly as it decoupled. This event frightened some USDT holders, leading to redemptions of their tokens for dollars amounting to $10 billion. For context, Tether redeemed more than half of the entire circulating supply of UST within a week, and there was no decoupling (it did not fall below $0.99). This was the largest batch of redemptions to date, but no systemic issues arose.

Putting aside volatility and redemptions, what directly supports USDT, and is it safe? Well, these uncertainties prompted Tether to release a quarterly audit report detailing its reserves. These reserves are currently audited by the accounting firm MHA Cayman, located in the Cayman Islands. We highlight the following latest audit details.

We see that USDT is not backed by cash (or cash equivalents) on a 1:1 basis, but more like 0.85:1. A closer look at cash and cash equivalents shows that just over half is allocated to U.S. Treasury bills, about 30% is allocated to commercial paper (CP) and CDs. The remaining 16% is allocated to money market funds (about 10%), cash and bank deposits (about 6%), non-U.S. Treasury bills (about 0.4%), and reverse repos (0.15%).

As for the remaining 14.36%, the audit did not provide further clarification. The allocation to corporate bonds, funds, and precious metals (4.52%) did not provide details on the types of corporate bonds (investment grade, country) and fund types. The types of precious metals were also excluded, and the percentage breakdown for these three categories is opaque. Secured loans (3.82%) had no disclosures, but it was mentioned that other investments (6.02%) do include digital assets, though the extent is unclear.

History

Since 2017, Tether has engaged several different banks, law firms, and accounting firms to provide services to verify the scale and effectiveness of its reserves. These firms include MHA Cayman, Moore Cayman, Deltec Bank, FSS, and Friedman LLP. Below we discuss a brief history of these relationships.

In 2017, as the pressure on USDT reserves increased, Tether invited the accounting firm Friedman LLP to conduct a reserve audit, but critics emphasized that the study had methodological flaws and did not represent a complete audit. Shortly after the first audit, Tether reported that Friedman had not completed the audit in what they considered a "reasonable time" and terminated the relationship.

Tether then turned to the Washington-based law firm FSS. The FSS report was not a comprehensive audit of Tether but stated that the law firm received sworn and notarized statements from two (unnamed) banks of Tether. To help build confidence, Tether had the Bahamian bank Deltec issue a report confirming the amount of cash in Tether's accounts there, but this also did not provide a complete picture, as it was only the cash value from one bank.

In 2021, the New York Attorney General's office completed an investigation, stating that Tether had overstated its reserves and concealed approximately $850 million in losses. This led to a $18.5 million fine and a requirement to publish quarterly reports of its holdings for two years. Around the same time, Tether announced a partnership with the Cayman Islands accounting firm Moore Cayman. Moore provided assurance reports confirming the full backing of USDT, followed by more detailed reserve breakdown reports. However, since January 2022, MHA MacIntyre Hudson has stated that its Cayman Islands subsidiary MHA Cayman would handle Moore Cayman's clients. It should be noted that MHA MacIntyre Hudson is currently under investigation by the UK's Financial Reporting Council for a prior audit of an unrelated company.

As mentioned, the reserve breakdown was only provided starting from June 30, 2021 (after other stablecoins began to be issued). In most cases, since June 2021, the allocated weights have remained relatively stable, with cash and cash equivalents slightly increasing from 85% to 86%, while secured loans remained at 4%. However, other investments (including digital assets) have doubled from 3% to 6%, increasing the risk level of the reserves. The growth in other investments has come at the expense of corporate bonds, funds, and precious metals, which decreased from 8% to 5% during this period. In dollar terms, cash and cash equivalents increased by 7% in the most recent quarter, while secured loans decreased by 24%.

A deeper dive into cash and cash equivalents shows that U.S. Treasury bills have begun to constitute a larger portion of reserves (from 24% to 48%), replacing the dominance of commercial paper and CDs (from 49% to 24%). The reduction in commercial paper holdings has somewhat alleviated concerns about the risks of these instruments. Cash and bank deposits decreased from 10% to 5%, and reverse repo notes decreased from 2% to 0.1%. Money market funds have also increased, now accounting for 8%, and non-U.S. Treasury bills have also increased (0.3%) in the most recent quarter.

The quality of Tether's commercial paper continues to be questioned, even as its allocation has been reduced. Below we show the rating breakdown of Tether's commercial paper as of March 2022.

From June 2021 (when Tether began reporting its reserve breakdown) to March 2022, Tether's reserves grew from $63 billion to $83 billion, an increase of 31%. This growth included a 32% increase in cash and cash equivalents, a 25% increase in secured loans, a 23% decrease in corporate bonds, and a 141% increase in other investments (possibly due to rising digital asset prices).

However, since March 31, 2022, there have been approximately $10 billion in redemptions (scaling down from about $84 billion to $74 billion), with no adverse effects. The redemption process involves a one-time verification process of $150 and a 0.1% fee, with the current minimum redemption amount set at $100,000. If an asset run occurs, these restrictions may slow down the process, but there is evidence that Tether has been able to handle billion-dollar level redemptions over the course of more than a week.

Comparison

So, how do Tether's reserves compare to leading money market funds? As noted in the audit report, 8% of Tether's reserves consist of money market funds, although the details of these funds have not been disclosed. We examined the portfolios of several top money market funds by assets under management and compared their holdings as of the last quarter. We see that while commercial paper, repurchase agreements, and certificates of deposit seem to be popular choices, mutual funds can have significant variations in fixed-income holdings.

While comparing the differences between money market funds and stablecoin reserves is useful, it is not entirely a like-for-like comparison. Below we highlight the reserve details of the two largest stablecoins by market capitalization, Circle's USDC and Binance's BUSD.

BUSD, founded by Binance and Paxos, does not break down the weight between cash and U.S.-backed debt. BUSD's reserves are audited by Withum (which also audits other stablecoins).

Tether is the first mainstream stablecoin and has held a dominant market position for years. However, recently, Circle's USDC and Binance's BUSD have gained significant market share among mainstream stablecoins (approximately ~37% and ~13%, respectively).

Additionally, Tether accounts for about 33% of the market share in all stablecoin/BTC trading volume on trusted exchanges, although this is also gradually diminishing. The relative importance of USDT is clearly declining.

All three stablecoins are pegged to the dollar at a 1:1 ratio, with Circle and Binance/Paxos required to undergo and publish monthly audits, while Tether is on a quarterly reporting schedule. While USDT always shows its reserves, it does not provide public information about the audits, which may be a concern for investors. Despite differences in transparency reporting, there are some differences in reserves among these stablecoins. We highlight some more differences between these three stablecoins below.

The world's most popular stablecoin, Tether, has withstood many tests and some black swan events since its inception in early 2015. The first-mover advantage, combined with real-world tests, has increased confidence in USDT, as evidenced by the growth in circulating supply. However, the real test may not have come yet, as renewed scrutiny of stablecoin reserves has led to a 12% reduction in USDT circulation due to recent redemptions.

Moreover, competitors like Circle enjoy more transparent reporting in a more trustworthy regulatory environment. This sense of security with USDC (and other stablecoins) continues to lead to a decline in Tether's market share.

As previously observed, this trend may lead Tether to adopt more robust reserves, greater transparency, and more diligent auditing practices.

Of course, Tether could also choose to remain complacent, disregarding trustworthy transparency, market share, and the reduction in supply scale, but this would significantly diminish Tether's market influence.

If the first path is taken, it reduces risks for everyone, but if the second path is taken, then the question "Is Tether a systemic risk to the cryptocurrency market?" becomes less significant.